October 23, 2012

The March 2012 New York Times editorial by former Goldman Sachs executive Greg Smith accused the firm's culture and practices of being centered around "ripping their clients off." Smith followed-up on his editoral yesterday by publishing a full-length book on his time at Goldman and an editorial criticizing much of the financial services industry.

While the soundness of Smith's criticisms leave much to be desired, last week the New York State Supreme Court refused to dismiss an October 2011 lawsuit against Goldman that, much like Smith, faulted Goldman for "putting profits above integrity...to the detriment of its own clients." The case is Basis Yield Alpha Fund (Master) v. Goldman Sachs Group Inc et al., New York State Supreme Court, New York County, No. 652996/2011.

The suit was brought by a hedge fund claiming that Goldman sought to reduce its exposure to subprime mortgages by selling mortgage-related securities to the fund as sound investments without disclosing Goldman's negative view of the securities or its economic interest in their failure.

The court refused to dismiss the fraud claims because it found that the fund laid out in sufficient detail specific misrepresentations by Goldman.*

But the court went further. It held that the fund's fraud claim was also supported by Goldman's overly optimistic opinions about the value of the transactions allegedly made to the fund. These opinions included statements that the transaction was "attractive" and "rock solid."

Goldman argued in a motion that, even if the opinions were actually stated, they don't lay the basis for a fraud claim because they were merely sales talk and puffery--as distinct from misrepresentations of actual fact. A general principle of business and securities law is that opinions cannot serve as the basis for a fraud claim. Moreover, Goldman argued, any statements of opinion are irrelevant in light of the specific disclaimers that were made about the risks of the transactions.

But the court didn't buy Goldman's arguments.

Relying on prior cases finding that it is fraudulent for a seller to state an opinion that's unreasonable or that the seller does not genuinely believe, the court found as sufficient the fund's allegations that Goldman believed the securities it sold were toxic and that Goldman was motivated to remove the securities from its balance sheet. Likewise, the court found the disclaimers in the transaction's offering documents insufficient to dispose of the fund's fraud claim. This is because of other allegedly fraudulent statements Goldman made outside of the offering documents--in emails to, and calls with, the fund.

A primary lesson from the case thus far is that, to avoid civil liability, firms that use securitization vehicles to transfer risk should not opine as to the quality of securities they are issuing. They should also give the buyer a breakdown of the transactions directly related to the securitization that they are involved in, as well as their relationship with third parties that help structure the vehicle.

A major problem with the opinion is that it allows sophisticated parties like hedge funds to bring suits on the basis of having relied upon opinions, albeit insincere ones. In doing so, it undermines the incentive for sophisticated buyers to do their own research and negotiate for more disclosures and favorable deal terms.

A primary cause of the subprime mortgage crisis was investors' failure to perform their own research or hire independent parties, and the court's decision does not alleviate that problem. To the contrary, it gives implicit approval to buyers to rely on the opinions of sellers when they probably should be ignoring them altogether.

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*Those allegations relate to Goldman's internal valuation of the securities, the independence of the underlying asset selection process, and whether Goldman's interests were really aligned with the fund's.

June 26, 2012

Later this year, a U.S. appellate court will decide whether sovereign immunity shields a nationalized Irish bank from claims by two investment funds holding notes issued by the bank. The decision will likely have broad implications for holders of European bank debt as the ongoing European debt crisis has already caused several banks to be nationalized (including Spanish bank BFA-Bankia in May) and more nationalizations may be on the way.

The Second Circuit Court of Appeals will be reviewing the November 2011 district court decision in Fir Tree Capital Opportunity Master Fund v. Anglo Irish Bank Corporation Limited. In 2005, two private investment funds organized in the Cayman Islands purchased $200 million in notes issued by the Anglo Irish Bank which was later nationalized in 2009. The lower court dismissed the funds' request to stop the bank from merging and liquidating its assets, and to set aside enough money in the U.S. to pay the funds back. The court's basic reasoning was that, after being nationalized, the Anglo Irish Bank was endowed with sovereign immunity under the Foreign Sovereign Immunities Act and hence beyond the court's jurisdiction.*

Creditors in European banks and other firms that have been or may be nationalized can take several actions to reduce this type of credit risk that arises from a non-U.S. debtor becoming immune to claims due to nationalization. These actions include charging higher interest to compensate for nationalization risk, an up-front waiver of sovereign immunity, organizing investment entities in the U.S. to benefit from U.S. treaties with other nations, or segregating a foreign bank's assets in a special purpose entity in the U.S.

Another method bank creditors can use is contractual. The notes (or a related agreement) should include a provision that expressly recognizes nationalization (or actions taken prior to nationalization) as an event of default that empowers creditors to accelerate their right of repayment. The court in Fir Tree highlighted the fact that the funds' notes did "not directly address the ramifications of a nationalization."

A May 2012 synthetic collateralized debt obligation exemplifies this contractual approach to protecting creditors from nationalization risk. As noted by Christopher Elias,

Following recent clashes in New York courtrooms between investors and nation states over sovereign immunity on nationalized assets, the debt programme includes a “nationalisation” trigger in its extraordinary events. The extraordinary events provide that upon a merger event, a de-merger, de-listing, insolvency or nationalisation, then the calculation agent may decide in good faith to apply a method of substitution with respect to the affected shares or ADRs. The method of substitution provides that affected shares or ADRs may be converted into cash and the proceeds reinvested in new shares or new ADRs.

This provision protects synthetic noteholders by permitting payments to be adjusted to events post-nationalization.

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*The court also rejected several arguments raised by the funds. The court found that sovereign immunity was not waived by the Irish government, that as Cayman Island-organized funds the plaintiffs were not entitled to protection under any U.S.-Irish treaty, and that the bank's conduct post-nationalization did not constitute the type of "commercial activity" required to pierce soverign immunity.

October 18, 2011

It seems hard to criticize the August 2011 decision by the Grand Court of the Cayman Islands that found two hedge fund directors liable for $111 million for willful neglect in failing to effectively oversee the Weavering Macro Fixed Income Fund. The fund ultimately suffered a $530 million collapse due to fraudulent interest rate swap transactions which likely could have been avoided with more diligent oversight. The directors seemed more interested in pleasing the manager, to whom the directors were both related, than actually conducting oversight, the court noted.

Most commentators welcomed the decision as a reminder that hedge fund directors must play an active role in the fund, while others viewed the case as reaffirming the importance of hedge funds hiring professional outside directors.

As noted by hedge fund counsel and adviser Ian Dillon, however, some of the court's language may have far reaching implications for hedge fund directors and fund governance more broadly. According to Dillon, the judgment may reduce the ability of directors to rely on service providers and excuse service providers from conducting any of their own oversight.

The judgment suggests that placing reliance on the work done by highly qualified, and in many cases highly paid, professionals in relation to the preparation of a fund for launch, including the drafting and assembly of all of the relevant fund documents, is well below the standard required.

Further it seems to require independent director’s to undertake a level of review and work that requires a second guessing of the conduct and work of the lawyers, accountants and other professionals, a second guessing the full scope of which many professional directors may be uncomfortable undertaking.

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Perhaps even more worrying...is the judgments suggestion that other service providers to the fund, such as administrators and auditors, have a very limited responsibility to the fund, its investors and indeed the directors, when it comes to reporting unusual activity...it seems unusual (to say the least) that they have no obligation to point out unusual, and at times down-right extraordinary, behaviour, even when perhaps it has inadvertently come to their attention.

The decision also wrongly implies, according to Dillon, that as a matter of industry practice hedge fund directors conduct their own thorough verification of documents provided by lawyers, administrators, and other service providers. His commentary is worth reading in full.

September 16, 2011

On August 26, 2011, the Grand Court of the Cayman Islands found directors of the collapsed Weavering Global Macro Fund liable for willful neglect and responsible for $111 million in damages. While the court's decision and reasoning was overwhelming sound, it would have been helpful for the court to more fully consider the broader relevance of the fact that the directors were not being paid (which is discussed breifly in paragraph 11 of the opinion). Although the court suggested that the amount directors are paid may be indicative of the precise scope of their legal responsibilities beyond a threshold level, it should have more fully explained the relationship between director pay and legal responsibility. This is because hedge fund investors would benefit from better understanding to what extent courts may subject directors to enhanced duties because of their compensation, and subsequently tailor their diligence and monitoring accordingly.

I make the foregoing point and offer more analysis in a short article forthcoming in the Cayman Financial Review, which I will link to here once it is published.